Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Tuesday, November 01, 2011

European Commission Proposes Regulation Extending Insider Dealing to Derivatives Trading and New Directive on Criminal Sanctions

In an effort to combat insider dealing and market manipulation, the European Commission has proposed a Regulation under the Market Abuse Directive extending its scope to commodity and related derivative markets and reinforcing the investigative and sanctioning powers of regulators. Separately, as part of the effort to get tough on insider dealing, the Commission proposed a new Directive for Criminal Sanctions on Market Abuse. According to Commissioner for the Internal Market Michel Barnier, market abuse is not a victimless offense because, by distorting market prices, insider dealing and market manipulation undermine investor confidence and market integrity. By extending and reinforcing the EU legislative framework, said the Commissioner, as well as toughening up the powers and sanctions available to regulators, the proposals will equip them with the tools to keep markets clean and transparent.

Insider dealing consists of a person trading in financial instruments when in possession of price-sensitive inside information in relation to those instruments. Market manipulation occurs when a person artificially manipulates the prices of financial instruments through practices such as the spreading of false information or rumors and conducting trades in related instruments. Together, these practices are known as market abuse.

The proposed Market Abuse Regulation seeks to adapt EU regulation to the new market reality by extending its scope to financial instruments traded on new platforms and over the counter, currently not covered by EU legislation. The proposal clarifies that market abuse occurring across both commodity and related derivative markets is prohibited, and reinforces cooperation between financial and commodity regulators. The proposal includes a number of measures to ensure that regulators have access to the information they need to detect and sanction market abuse. Since the sanctions currently available to regulators often lack a deterrent effect, the proposal introduces tougher and greater harmonization of sanctions, including possible criminal sanctions which are the subject of a separate but complementary proposed Directive. The proposal is tailored for small and medium-sized issuers in several respects.

The regulatory framework provided by the original Market Abuse Directive has been outpaced by the growth of new trading platforms, OTC trading and new technology such as high frequency trading. The proposed Regulation extends the scope of existing EU legislation to financial instruments traded on multilateral trading facilities, other organized trading facilities, and OTC so that trading on all platforms and of all financial instruments which can impact them will now be covered by market abuse legislation. It also clarifies which high frequency trading strategies constitute prohibited market manipulation, such as submitting orders without an intention to trade but to disrupt a trading system, so called quote stuffing.

Commodity markets have become increasingly global and interconnected with derivative markets, noted the Commission, leading to new possibilities for cross-border and cross-market abuse. The scope of the legislation is therefore extended to market abuse occurring across both commodity and related derivative markets.The proposed Market Abuse Regulation extends the current reporting of suspicious transactions to suspicious unexecuted orders and suspicious OTC transactions. It grants regulators the power to obtain telephone and data traffic records from telecoms operators or to access private documents or premises where a reasonable suspicion exists of insider dealing or market manipulation. A prior judicial warrant is also required for access to private premises. It also requires Member States to provide for the protection of whistleblowers and sets common rules where incentives are offered for reporting information about market abuse. Finally a new offense of attempted market manipulation is introduced to make it possible for regulators to impose a sanction in cases where someone tries to manipulate the market but does not succeed in actually trading.

Common principles are proposed, notably that fines should not be less than the profit made from market abuse where this can be determined, and the maximum fine should not be less than two times any such profit. In parallel, the proposed Directive on Criminal Sanctions for Market Abuse requires Member States to introduce criminal sanctions for the offenses of insider dealing and market manipulation where these are committed intentionally.

Enacted in 2003, The Market Abuse Directive is based on the concept of prohibiting insider dealing or market manipulation in financial instruments which are admitted to trading on a regulated market. However, financial instruments have been increasingly traded on multilateral trading facilities and on other types of organized trading facilities, such as swap execution facilities. These new trading venues and facilities have provided more competition to existing regulated markets, gaining an increased share of liquidity and attracting a broader ranger of investors. But the increase in trading across different venues has made it more difficult to monitor for possible market abuse.

Therefore the proposed Regulation extends the scope of the market abuse framework to apply to any financial instrument admitted to trading on an MTF or organized trading facility, as well as to any related financial instruments traded OTC which can have an effect on the covered underlying market. The proposal is designed to avoid regulatory arbitrage among trading venues and set a level playing field, as well as to ensure that market manipulation of OTC derivatives, such as credit default swaps is clearly prohibited.

The Market Abuse Directive currently requires Member States to adopt administrative sanctions but leaves them free to decide whether or not to impose criminal sanctions. The result of this discretion is an insufficient sanctions regime, said the Commission, resulting in ineffective enforcement of the Directive. For example, five Member States do not provide for criminal sanctions for disclosure of inside information by primary insiders and eight Member States do not do so for secondary insiders. Since market abuse can be carried out across borders, said the Commission, this divergence undermines the internal market.

The Directive for Criminal Sanctions on Market Abuse was proposed to remedy the situation by requiring Member States to criminalize intentionally committed insider dealing and market abuse, as well as aiding and abetting insider dealing and market manipulation. Some transactions are excluded from the scope of the Directive, including buy-backs and stabilization programs, monetary policy and debt management activities, and activities concerning emission allowances in pursuit of climate policy.

The proposed Directive requires Member States to ensure that the criminal sanctions are effective, proportionate and dissuasive. The Directive includes a review clause requiring the Commission to report to the European Parliament and Council within four years of the Directive's entry into force on the application of the Directive and, if necessary, on the need to review it, in particular with regard to the appropriateness of introducing common minimum rules on types and levels of criminal sanctions.